7 min read

Walk the Jewels

Between two worlds, tryna get dough, ya know?
Walk the Jewels

What’s going on?

  1. Putin’s plan to ban exports of coniferous round timber starting in 2022 is splitting the industry between producers with value-added production that would benefit from the feedstock in case of shortages and those companies completely reliant on sales of felled timber. The real fight is over exports to the Chinese market and long-standing anger over illegal logging activity in Siberia . In the end, the ban hits SMEs in the Far East hard. Chinese consumers, however, will be  just fine.
  2. There is, as of yet, no agreement within the government over investment plans to modernize the national power grid, particularly for the Far East. The market council’s current base case has energy prices rising at 5% - above the CBR’s 4% broad inflation target rate - by 2027. The pessimistic case shows energy pricing rising nearly 6% in 2025, 9.4% in 2026, and then settling lower towards 4.4% by 2032. Electricity tariffs are rising a mere 0.09% annually to cover the costs of conversion to smart meters and disagreements persist over what demand growth looks like. More importantly, declines in returns for OFZ bonds (used for financing) and the potential depreciation of legacy assets from future capacity gains for renewables threaten expected profits from modernization.
  3. Facebook and Twitter have been denied an extension till October 2022 to host users’ data on servers in Russian territory per the relevant regulation that came into force on September 1, 2015. Roskomnadzor has clarified that fines may be levied for violations, but any decision to block the use of either site akin to LinkedIn’s blocking in 2016 would require a “political decision.” Both companies were fined by court order earlier this year and refused to pay the fines, one imagines at least in part, because of the inevitably terrible press on their home market in the United States. Any earlier effects for market participants from the law entering force are probably fading, though the MOEX tells a mixed story on the state of the expectations around tech and software.
  4. The roll-up of anti-crisis support measures begins to take effect today as entrepreneurs who lost their businesses and jobs because of COVID-19 are no longer eligible to receive unemployment benefits at the max level (12,130 rubles) and the rent holiday for small and medium-sized businesses is now ending. The rollup comes 3 weeks after PM Mishustin issued an order allocating an additional 35.3 billion rubles ($456.4 million) for unemployment benefits across the country.

Tax bros

MinFin’s taking advantage of the current oil market crisis to push for combined plans to raise 2 trillion rubles ($25.9 billion) of new tax expense revenues to reach 5 trillion rubles ($64.8 billion) annually in 2023 with yet more tax maneuvering. Citing BP’s current scenario forecasts with oil demand peaking in 2025, the aim is to scare decision-makers into realizing just how bad the long-term revenue outlook is with continued reliance on the oil & gas sector to build the budget. They’re taking explicit aim at Rosneft’s own aggressive statements about BP and Shell’s gloomy (but, I believe,  accurate) prognoses. This chart knocks it out of the park in just how bad the picture is and why MinEnergo has been adamant that without further tax reforms for the sector, oil production would plateau in the next few years and likely enter slow but steady decline come 2025.

Title: Effectiveness of Tax Breaks for the Oil Sector, trln rubles

Red = EBITDA Black = Tax Breaks’ Share of EBITDA Blue Line = Investment

EBITDA has risen primarily because of currency devaluation since prices never recovered to their 2008-2013 peaks after 2014, save a brief spell at around $85 a barrel in October 2018 thanks to US sanctions on Iran, Venezuela, and related speculation on further sanctions. The explosion of tax breaks to sustain production levels at legacy assets and develop more remote deposits is a structural legacy of failing to reform the tax code when the sector first hit an investment wall in 2007 - the majority of output growth between 2000 and 2006 was Yukos implementing best practices to maximize production, not manage it as Lukoil might have. And instead of replacing regressive tax calculations for MET and export tariffs that increase as prices rise, they opted to offer tax concessions on an ad hoc basis and smaller-scale “experiments” with taxing profit instead. Remove the tax breaks, it’s clear devaluation’s doing the work for EBITDA gains, especially once OPEC+ is introduced in December 2016, thus capping production. That’s obviously going to be significantly worse this year, though it’s cushioned by foregoing tax collection in some instances and other forms of support.

MinFin wants to raise 300 billion rubles ($3.9 billion) by increasing the tax burden on the oil sector, arguing that those same tax breaks are evidence that the companies themselves have to do a better job lowering their costs and upping profits. But in practice, MinFin is walking back some of the last decade’s changes. The sector’s overall tax burden fell from 45% in 2011 to 38% in 2017 as the tax maneuver was getting underway. Plus tax burdens aren’t evenly spread - Rosneft pays close to the sector average, whereas last year, Lukoil has average a rate closer to 15% with its strategy. That will inevitably end up undermining VAT collection from the sector in time. The threat of peak oil has pushed budget hawks to seize the moment given the fiscal fortress approach to state finances.


Meet the New Boss, Same as the Old Boss?

Henry Foy’s writeup in the Financial Times covering the furor in the metallurgical sector over the Duma’s tax hikes is a great read. On its face, it’s a classic lobbying interest story in Russia where, due to a mix of budget needs, public crisis, and political convenience, Belousov stonewalled the sector hard. But the aggressiveness of MinFin’s scramble to raise revenues - and avoid visiting too much of the burden onto the population to maintain consumer spending - is, in some respects, an energy transition story in waiting. Domestic macro and global trends collide.

Title: Who’s bankrupting Russian citizens?

Small Dot = Federal Tax Service Medium Dot = Creditors Big Dot = Debtors themselves

In 2016, 19,600 Russians declared bankruptcy. By 2019, that figure reached 69,000. The first half of this year, the figure was 42,700. In the big scheme of things, this isn’t exactly an earthquake but it signals a basic problem with austerity, even when you shunt the burden onto oil, gas, mining, and other big sectors. A business survey carried out by the now infamous Otkrytiye found that 7% of businesses claimed COVID had force them to shutter and over a third of businesses had cut wages. When you combine a recessionary shock to wages from COVID-19, an attempt to extract more tax from large businesses that will likely adjust investment plans downward, and relatively limited state support for incomes that have alternated between stagnation and decline for six years, inevitably the fiscal discipline of the state budget comes at the cost of greater risk taking and borrowing elsewhere.

What makes the latest increase in tax on the mining sector interesting to follow is precisely the unclear nature of whether or not the tax hikes are temporary or stay. My conjecture is that tax revenues are likely to rise because of the impacts of the energy transition, which could, in theory, provide more fiscal space to spend on social services, invest, or else try to appease the public given numerous policy failings that have continued for years. For those interested in recycling, here’s the link to paper I pulled the following graphs from summarizing demand projections for different metals and minerals from tens of forecasts.

These cover the gamut, but the real standouts are lithium, copper, nickel, eventually cobalt, tellurium, selenium, and precious metals (here, silver and platinum). Some of these processes, it should be noted, concern refining and cross-sector applications. The profits that Russia’s mining sector will realize in coming years, especially if the ruble remains weaker, could be very strong. There are clearly limits imposed by geography, climate, and Russia’s transport infrastructure, so one hopes that efficiency gains are made. The current tax hike is not going to encourage big investments to gain market share via large production increase since it penalizes rapid production growth, but it could, with more direction, be used to spur efficiency gains. But the larger story to come is how MinFin and budget hawks adapt as commodity prices for these inputs likely rise and companies scramble to grab foreign market share (and foreign currency earnings) to improve their financial position as long as the ruble continues to be volatile with considerable downside risks. The US elections are going to have an interesting impact on the future of commodity market demand depending on the policy consequences. Fears that tax hikes may be permanent are well-founded. The oil sector tax code that’s so regressive with price increases was passed in 2001, before the commodity price boom in the 2000s. Once prices skyrocketed, the revenues were too good to turn down. If it sticks, one hopes that Russians across the country might get a slice of what’s raised. Personal finances are going to continue to fray, especially if tax maneuvering ends up discouraging further business investment to create jobs.


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